US Strategy Weekly: What We Are Watching

Stats and Treasuries
There will be a lot of news impacting the equity market in the coming months including economic data that could become quite ugly. But if we had to choose only two bits of data to watch in order to measure the risk/reward of the equity market, it would be the daily statistics on the virus in the US (looking for a peak in both new cases as well as deaths) and the 10-year Treasury bond yield. To a large extent we believe the debt market will be the best guide for equity investors in coming months. The 10-year US Treasury bond is valuable because it is a global market instrument, and as such, it incorporates information regarding global economies, politics, sentiment and liquidity. Since many investors view the US Treasury bond as a safe haven investment, it may be the best sentiment indicator to monitor in 2020. If this is true, it is possible that the March 9 record low of $4.99 in the 10-year Treasury yield index (TNX – $9.97) represented a peak in global panic; and if so, it is also possible that this panic low marked the beginning of a bottoming process for many financial markets.

Fundamentals are Fuzzy
Still, there are many things we are monitoring and perhaps the most challenging is assessing fundamentals. It will be months before we have data on first and second quarter GDP. But in mid-April first quarter earnings season will begin and the corporate guidance that accompanies these reports will give us our first clues as to how corporate America will be impacted by the COVID-19 crisis.

We can expect that it will generally be bad news and earnings estimates will come down. But keep in mind that many segments of the economy are doing well. Healthcare, pharmaceuticals, personal care products, communication services, utilities, e-commerce, delivery services, and videoconferencing will be among the industries that will be beneficiaries of the current situation. Yet many companies will be hurt, and one can expect shakeouts in some sectors such as energy and retail. In the interim, we can try to measure the risk in the overall market by assuming there will be an earnings recession in 2020. Therefore, it is reasonable and prudent to look at the risk in the equity market if earnings decline 10%.

Based upon the current level of inflation and the benign interest rate backdrop our valuation model suggests an average PE of 17.2 X is appropriate for both this year and 2021. S&P Dow Jones estimates earnings were $157.10 in 2019 which means a decline of 10% would suggest earnings of $141.39 in 2020. Applying a PE of 17.2 to $141.39 translates into a fair value target of SPX 2430 for 2020. As seen in our valuation model on page 3 and the charts on page 6, the SPX has already traded below that level. Yet, if we take this one step further and project a second 10% earnings decline in 2021, SPX earnings fall to $127.25 and the mid-point of our forecasted trading range drops to SPX 2340 in 2021. We believe this is very unlikely, but it is a valuable exercise and it shows that the March 16 close of SPX 2381 came close to discounting a two-year earnings recession, or a 20% decline in earnings.

Another way of looking at a worst-case scenario for the market would be to use $141.39 earnings in 2020 and a long-term average PE ratio of 15.5 times. This lower PE multiple could apply if there were uncertainty regarding the longer-term prospects for earnings growth. Earnings of $141.39 and a PE of 15.5 X translates into downside risk to SPX 2191. All in all, these exercises indicate that fundamental factors point to a wide range of possibilities, but the SPX 2400 and SPX 2200 levels tend to be areas of fundamental support.

Technicals Worth Noting
In the last 17 trading sessions, there have been seven trading sessions where volume in declining stocks represented 90% or more of the day’s total volume. These days are classic examples of panic selling and three of these seven down days were Mondays, representing classic Panic Monday selling sprees.

History suggests that the worst of the selling pressure tends to be over once buyers come back to the market in earnest and this shift is represented by a 90% up day. Indeed, after the March 12 close of SPX 2480.64, a 93% up day materialized on March 13 (Friday). Nevertheless, this 93% up day was followed by another disastrous Monday decline in which 93% of the volume was in declining stocks, the advance/decline ratio was 1 to 15 and the daily new high/low ratio was 1 to 65 and the market fell to a new low of SPX 2386.13. Volume was only slightly above the 10-day average since circuit breakers interrupted trading twice during this session. These circuit breakers are one of the ways the current market structure differs from historical precedent. They make it more difficult to find that high-volume big-decline capitulation day that washes out the market and often defines a significant low. Nonetheless, there is no doubt that volatility is at record levels and as we showed last week, to date, March 2020 has been more volatile than any month during the Crash of 1929. This is amazing since that crash preceded the Great Depression, a global trade war, a broken banking system, and the Dust Bowl that joined forces in 1930. Things are far less dire today.

But when we look at current breadth data, we do find similarities to the 2011 low. The 2011 decline was precipitated by a well-anticipated downgrade of US sovereign debt on August 8, 2011 and it was linked to a belief that a recession was at hand. The choppy August to October 2011 period was characterized by a confusing pattern of alternating 90% down and up days; yet when we look closely at that period we find that the first 90% up day occurred on August 9, 2011 (see arrow on page 7). This up day followed the August 8 low of SPX 1119.46. Although the ultimate low for 2011 did not materialize until October 3, 2011 at SPX 1099.23, this lower low in October was merely 1.8% below the August 9 close. In sum, the first 90% up day did indeed indicate that the worst of the selling was over, and the bottoming process had begun. We believe this may also be true of today’s environment. While we expect much volatility in the weeks ahead, the March 12 low of SPX 2480.64 and the March 16 low of SPX 2386.13 (4% lower), is hopefully the beginning of a bottoming phase for equities. Note that the December 2018 low of 2351.10 — a significant support level — was also tested on March 16. When we look at the chart of the SPX, it is clear that the uptrends from the 2009 and 2016 lows have been broken. But the SPX chart also shows important support levels are found around SPX 2400 and SPX 2200. See page 6. Both of these levels coordinate well with the valuation benchmarks discussed earlier.

No Comparison to 2008
To date, the 29.5% drop seen in the SPX is greater than the long-term average decline of 24% and is the largest decline since 2008. See page 5. Although there may be reasons to compare the current marketplace to the 2008-2009 period, keep in mind that this is a medical crisis and not a liquidity crisis. Therefore, the recovery from this crisis should be much easier to accomplish once the virus subsides and/or a therapy and vaccine are in place. In 2009 earnings for the S&P 500 index went negative for the first time in history. To have the S&P 500 report a deficit for the year is far different from earnings declining by 10% or more. The SPX’s deficit in 2009 was due to massive profit losses in the banking sector. Today, after the virus peaks, the prospect for a rebound in earnings is substantial due in large part to a low unemployment rate and a strong banking system. It will not be simple, but the federal government has made it clear it plans to support small and medium sized companies and their employees during this unusual period. In short, the 2020 equity market is apt to provide investors with an excellent buying opportunity, but we expect prices will remain unpredictable and volatile for a long while.

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